Important legal information about the email you will be sending. By using this service, you agree to input your real email address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an email. All information you provide will be used by Fidelity solely for the purpose of sending the email on your behalf. The subject line of the email you send will be "Fidelity.com: "

Key takeaways

Do you actively trade mutual funds or ETFs? Or do you follow a sector rotation strategy, moving in and out of sectors depending on business cycle and market trends, with a portion of your overall well-diversified portfolio? If so, you might generate considerable short-term capital gains, which are taxed annually at high ordinary income tax rates. For investors in higher tax brackets, the impact to returns can be significant.

The good news is that there are ways to help reduce the tax bill. One strategy would be to make tactical trades in tax-deferred accounts, such as workplace savings plans, IRAs, and tax-deferred variable annuities. Tax-deferred variable annuities often are overlooked but, for investors who have maximized contributions to workplace savings plans and IRAs, they are an option worth considering.

With a tax-deferred variable annuity, gains on trades are taxed at withdrawal, enabling deferred growth potential.* Also, unlike retirement accounts, annuities have no contribution limits, a plus for higher-income investors. And annuities don't have required minimum distributions (RMDs), with many annuities allowing tax-deferred investing until age 90 or later.

And for those who engage in active trading, doing so inside a tax-deferred variable annuity can simplify an investor's life in other ways as well. In addition to no longer having to worry about paying the current-year tax liability from trades, you won't have to handle the tax recordkeeping and filing chore that goes with it. "You can focus on investing and adapting without considering tax implications," says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company.

Of course, there are caveats. Annuities can sometimes carry heavy fees, so you will want to shop for a low-cost product from a reputable provider. You may also sacrifice some liquidity because withdrawals of earnings before age 59½ are penalized. Investment choices may be limited. And in contrast to a taxable brokerage account, with an annuity you lose the opportunity to offset tax losses against gains or capture lower capital gains rates on withdrawals of long-term gains.

Still, for some higher-net-worth, active investors, the tradeoffs may be worth it. Says Tom Ewanich, "For an investor with a time horizon of 10 years or more, a tax-deferred variable annuity is worth looking into. Most people don't like paying more taxes than they have to, and the ability to control your distributions and potentially manage your tax bracket can be very attractive."

One approach to frequent trading: Sector rotation strategy

The business cycle has 4 phases that reflect fluctuations in the US economy, and each phase may have an effect on sector performance. Historically, some sectors tend to perform better or worse than others in certain phases. Monitoring the business cycle may help you determine which sectors you should focus your investing on during each phase.

One approach to frequent trading: Sector rotation strategy

Note: The typical business cycle shown above is a hypothetical illustration. There is not always a chronological progression in this order, and there have been cycles when the economy has skipped a phase or retraced an earlier one. Source for sector performance during business cycle: Fidelity Investments Asset Allocation Research Team. Sectors shown in the shaded areas of the business cycle have underperformed versus the US equities market during a particular phase of the business cycle, from 1962–2010. Annualized returns are represented by the performance of the top 3,000 US stocks measured by market capitalization, and sectors are defined by the Global Industry Classification Standard. Past performance is no guarantee of future results.

How much more can you keep?

Gains on investments held a year or less in fully taxable accounts are taxed at the investor's marginal income tax rate, which is typically much higher than the long-term capital gains tax rate. Married couples filing jointly with taxable income of more than $612,351 in 2019, for example, would owe 37% federal tax on short-term capital gains, and even more if they're subject to the 3.8% Medicare surcharge on investment income. In addition, state and local taxes could raise the total.

Long-term capital gains, on the other hand, are taxed at 15% for single taxpayers with taxable income between $39,376 and $434,550, and at 20% for those with income above that amount. For married couples filing jointly, the 15% range is $78,751 to $488,850, and the rate is 20% above that level. Long-term capital gains rates increase to 18.8% and 23.8% for taxpayers subject to the Medicare surcharge. And, again, state and local taxes can also raise the total rate.

Although earnings withdrawn from a tax-deferred variable annuity are taxed as ordinary income—the same as short-term capital gains—the effect of tax-deferred compound earnings over time is what can give a low-cost annuity an advantage over a fully taxable account for investors who trade frequently.

Plus, many people may drop into a lower tax bracket when they retire, further strengthening the case for paying taxes later rather than sooner. So for those who expect a drop in their income tax bracket as a result of lower taxable income, expect to move to a state with lower income taxes, or think that their tax rates will drop for any other reason after retirement, the use of a tax-deferred variable annuity can be particularly attractive.

Making a decision

If you have a longer time horizon, have already reached the maximum contribution limits in your 401(k) or IRA, and/or your investment approach lines up with the annuity's key advantages, a tax-deferred variable annuity may be suitable for you—particularly if you are thinking about a sector rotation investment strategy. Be sure to consult an investment professional as you develop your plan.

Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

*Tax-deferred annuities have no IRS-imposed contribution, and when funded with after-tax dollars, they don’t have a mandatory withdrawal requirement at age 70½ although there may be taxes and penalties for withdrawals prior to age 59½. Therefore, it’s important to consult an investment professional as you develop your plan.

The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.

Investing in a variable annuity involves risk of loss—investment returns and contract value are not guaranteed and will fluctuate.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

Past performance is no guarantee of future results.

Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.

Important Information

Virtual Assistant is Fidelity’s automated natural language search engine to help you find information on the Fidelity.com site. As with any search engine, we ask that you not input personal or account information. Information that you input is not stored or reviewed for any purpose other than to provide search results. Responses provided by the virtual assistant are to help you navigate Fidelity.com and, as with any Internet search engine, you should review the results carefully. Fidelity does not guarantee accuracy of results or suitability of information provided.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Fidelity does not provide legal or tax advice, and the information provided is general in nature and should not be considered legal or tax advice. Consult an attorney, tax professional, or other advisor regarding your specific legal or tax situation.